EU reaches consensus on derivatives exemptions

RivaFroymovich

(Updates with additional details on conflicts regarding legislation and which contracts will require clearance.)

BRUSSELS -(MarketWatch)- A consensus has emerged among the European Union's 27 countries to exempt most companies and short-term foreign exchange instruments from clearing obligations for derivatives, according to a person familiar with the matter.

While the countries continue to debate other aspects of the closely watched legislation, which seeks to tighten oversight of derivatives trading, the latest draft proposals from the European Council lean toward allowing the exemptions. Previously there has been some uncertainty over the future of forex transactions in the over-the-counter market.

In the aftermath of the financial crisis, all Group of 20 leading economies, including the EU, have committed to introducing laws by the end of 2012 that would require standardized over-the-counter derivatives to be cleared through central counterparties and traded on exchanges or electronic platforms. However the source said the EU will not hold to account companies seeking to use derivatives to mitigate risk.

"Anything with commercial activities...won't have to go through central clearing," below a still-to-be-determined threshold, said the person, who preferred not to speak on the record because the legislation is still under discussion.

Non-financial companies often use longer-term foreign exchange derivatives to hedge price fluctuations in the products they buy and sell abroad.

"The only question is how to define the clearing threshold and under what conditions," they would be obligated to clear, he said.

The council has also come in line with the foreign exchange industry's view that short-term currency contracts should be exempted from the rules because banks only hold the derivatives on their books for a few days, meaning they don't pose a long-term exposure that authorities may need to worry about.

The source said the main risk for these shorter-term contracts is around settlement, and this is already dealt with by CLS Bank, which operates a multi-currency cash settlement system.

The wording of the latest draft, dated April 11, underscores that point. It says that clearing requirements "may not be the optimal solution for dealing with settlement risk."

The $4 trillion foreign exchange market includes $2.5 trillion of over-the-counter currency derivatives trading. A derivative is a financial instrument whose value is based on anticipated price expectations, such as futures and options.

For corporates, the draft says that "consideration should be given to the purpose for which that non-financial counterparty uses derivatives and to the size of the exposures" it has. It also says that contracts entered into before these proposals become law would still have to comply with the regulation if the contract is outstanding.

A final decision on the EU rules will be taken by the European Commission, the bloc's executive arm. The source said the commission has opposed explicit exemptions in the regulation but will consider the positions of member countries and the European parliament, who must first agree a joint proposal. The European Securities and Markets Authority will also hold a consultation on the proposed rules.

Sharon Bowles, head of the parliament's economic committee, told Dow Jones Newswires Thursday there is also a basic consensus among lawmakers on exempting non-finanical companies from clearing requirements for derivative contracts. However, she cautioned that no final decision has been made and she said there is no agreement yet on whether to exempt short-term foreign exchange derivatives.

Gerard Hartsink, chairman of the banking industry's European Payments Council, told Dow Jones in an interview Wednesday that corporates may be exempt. Hartsink, who is also a board member of clearing house LCH.Clearnet and a member of the advisory group for the European Central Bank's Target2 Securities scheme, also said the ECB feels foreign exchange forwards and swaps would better be exempted from this regulation.

The European Commission put forward its proposals in September, but negotiations have gone longer than expected due to sharp differences over the scope of regulations.

While the commission's proposals don't go far beyond the G-20 agreement, many member countries want the legislation to apply to all derivative instruments and not just over-the-counter derivatives. Germany and Poland are just two countries that oppose this drive.

Expectations are low for these disputes to be resolved before the end of June, when Poland replaces Hungary as the new rotating EU presidency through the end of the year. The changeover could further stall the process.

Given the delays in drawing up the rules, some member states are already thinking that the first set of derivative rules that emerge from the process may require refining at a later date.

In its draft text, the council sets targets for after 2012 to review the use of derivatives in the energy sector and reconsider whether operability arrangements between central counterparties may be extended beyond cash securities.

The draft report can be found here: http://register.consilium.europa.eu/pdf/en/11/st08/st08857.en11.pdf

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.